In FLSmidth Ltd. v. The Queen, 2013 FCA 160, the Federal Court of Appeal (FCA) denied a foreign tax deduction under s. 20(12) in the context of a cross-border financing arrangement commonly known as a tower structure. The narrow issue arose within a fairly complex arrangement, which may be summarized as follows:
- the taxpayer (Canco) formed a US partnership (the US LP), which borrowed money and subscribed for all the shares of a Canadian unlimited liability company (the NSULC);
- the NSULC used these funds to subscribe for all the shares of a US limited liability company (the LLC);
- the LLC lent these funds to a company in Canco’s US group (US Co), which used the funds to acquire other US companies; and
- going forward, US Co paid interest to the LLC, the LLC paid dividends to the NSULC, the NSULC paid dividends to the US LP, and the US LP used some of these funds to pay interest on its borrowed money.
Further, each of the LLC, the NSULC, and the US LP were hybrid entities, in the sense they were treated differently for Canadian and US tax purposes. That is:
- the LLC and the NSULC were respected as corporations for Canadian tax purposes, but were completely ignored (as disregarded entities) for US tax purposes;
- the US LP was treated as a corporation for US tax purposes, but was respected as a partnership for Canadian tax purposes;
- for US tax purposes, the US LP paid US tax on what was seen as (net) interest income earned on a loan made directly by the US LP to US Co; and
- for Canadian tax purposes, the legal form was respected: the LLC earned interest income (active business income under s. 95(2)(a)(ii)), the NSULC received dividends from the LLC (deductible under s. 113(1)(a)), the US LP received dividend income from the NSULC and deducted interest paid on its borrowed money (s. 96 and s. 20(1)(c)), and Canco deducted under s. 112 the NSULC dividends received through the US LP.
Within the above context, the narrow Canadian tax question was whether the US tax paid by the US LP could be deducted under s. 20(12), in computing the US LP’s income under s. 96. The FCA said no. Two conditions had to be met under s. 20(12): first, the US tax had to be paid “in respect of” the US LP’s income from a business or property, and second, the US tax could not be seen as having been paid by Canco “in respect of” underlying dividends from the LLC. The FCA held that whether the phrase “in respect of” in s. 20(12) is construed narrowly or broadly, the appeal could not succeed (paragraph 45). If the phrase is construed narrowly, the first condition was not met because the US tax was not paid in respect of the US LP’s dividend income from the NSULC; rather, the US tax was paid by the US LP on its interest income (for US tax purposes) independent of any dividends from the NSLUC (paragraph 44). If the phrase “in respect of” is construed broadly, the second condition was not met because the US tax was reasonably regarded as having been paid by Canco (as a partner in the US LP) in respect of underlying dividends from the LLC (see paragraphs 34, 35, and 49). Either way, no deduction was available under s. 20(12).